Why You Should Care About Your 401k
Disclosure: This article contains references to products from one or more of our advertisers. We may receive compensation when you click on links to those products. For a full explanation of our Advertising Policy, visit this page for more information.
Do you know if you have a 401k through your employer, how to take advantage of your 401(k) or why you should take advantage of it?
Many young adults don’t. They accept a job mostly for the salary – everyone needs to get paid, after all.
However, if you’re not looking at the overall benefits package your job offers, you could be losing out.
I have to say, I’m super jealous of people who have 401(k)s through their employers, and even more jealous of those eligible for matching contributions.
The places I worked at never offered one, and even if they did, I’m not sure I knew what the worth of such a package was back then.
It seems as though plenty of my peers are in the same spot. If you don’t realize how awesome your 401(k) plan can be, read on to find out how to take advantage of it.
WHAT’S THE PURPOSE OF A 401K?
Very briefly, a 401(k) is the easiest way to get started saving for retirement. Yeah, that thing that’s looming about 40+ years on the horizon that you may have given some thought to.
I know it’s hard to stay focused on the end goal, but remember, you shouldn’t be working just to survive. You should be working to thrive so you can build the kind of life you want to live down the road.
Money you contribute to a 401(k) is on a pre-tax basis, which means that it grows tax-free, and is taxed upon withdrawal in retirement. We’ll talk more about this later.
Suffice it to say, the earlier you can start contributing, the better. With 401(k)s available at many companies, it’s a low barrier to entry for investing for many young adults.
This is key when it comes to taking advantage of compound interest. You want your contributions to earn interest, of course, but having your interest earn interest is even better! The earlier you start contributing, the better, as your interest has more time to gain momentum.
WHAT’S THE BIG DEAL ABOUT 401(K)S?
Okay, sounds interesting, you may be thinking. What’s the big deal?
A lot of people have an aversion to investing in the stock market, because they’re unsure of taking on so much risk. 401(k)s tend to be less intimidating to invest in, and they’re very simple to set up.
When you were hired, you likely filled out a bunch of paperwork you forgot about that’s lying around somewhere. Go grab that paperwork, and review the plan.
Some employers will enroll you in automatic minimum contributions, typically 3 percent of your salary. The money is taken out of your paycheck before you see it, so it’s a very painless way to train yourself to save for retirement since you won’t miss it!
In fact, you can increase your contributions by 1 percent per year, or whenever you get a raise, if you’re comfortable living off of your current paycheck.
Since contributions are automatic, you don’t have to think about saving, which is good if you’re prone to spending your paycheck.
Speaking of contributions, how much can you put in your 401(k)? The 2016 limit is $18,000, and if you’re 50 and older, you can contribute an additional $6,000 to catch up.
Most of the time, your HR department is the one handling all of this, so they’re the ones you should direct your questions to.
THE GUARANTEED RETURN YOU WON’T GET ELSEWHERE
The biggest deal about a 401(k) is having an employer match. Before you get excited about this opportunity, I want to note that not all matches are created equal. Your employer may (sadly) not even offer a match.
Some companies will offer a 100 percent match up to a certain percentage of your salary, which is insane. I was listening to The M.O.N.E.Y. Podcast recently, where blogger (and super saver) J. Money spoke about his incredible match: “100% of 100% of whatever you put in.”
He went all-in: he contributed 94 percent of his salary to his 401(k) for a few months to max it out, and he received a paycheck of $19 during those months. Talk about dedication! His haste paid off when the company went under four months later.
There’s a reason for the enthusiasm behind matching contributions. They’re essentially a guaranteed return – one you won’t get elsewhere. Let’s look at how this can play out.
A 2013 study by Aon Hewitt revealed that the most common employer match is 100 percent up to the first 6 percent of your salary. What does that look like? Say your annual salary is $45,000. 6 percent of that is $2,700. So you know you need to contribute $2,700 for your employer to contribute another $2,700.
You can always contribute more than that, but you’ll no longer receive the matching contribution since it’s up to 6 percent of your salary. If you contribute less, then your employer will only contribute what you did. That means you’re losing out on free money.
In Jay’s extreme case, he contributed the maximum of around $16,000 (at the time), and his company contributed the same to his account. That’s $16,000 of free money.
Where else in the world are you going to find a return on your money like that? If your employer offers it, you need to take advantage of it. Otherwise, you’re leaving a lot of potential behind.
I realize it can be difficult to part ways with your money, especially when it’s (mostly) locked away until retirement, but it’s a must if you have an excellent match.
TAX ADVANTAGES OF A 401(K)
Along with the guaranteed return and making saving for retirement painless, most 401(k)s are also tax-deferred, meaning contributions aren’t subject to federal income tax. Your earnings grow tax-free, although your withdrawals will be taxed later on.
That also means your contributions directly lower your taxable income. This is due to the fact you’re making contributions with pre-tax dollars. If you’re earning $45,000 and contribute $3,000, then your taxable income is $42,000.
For those of you earning more, this could put you in a lower tax bracket. Either way, you’re saving money on your income tax.
IT’S NOT ALL SUNSHINE AND COMPOUND INTEREST…
401(k)s have lots of advantages, but there are some disadvantages to be aware of.
The biggest one: what if your employer doesn’t offer a match? Is it still worth contributing? Sometimes, the tax benefits can be more beneficial than investing in an outside account, but you need to run the numbers (or consult a financial advisor) to see what the right decision is for you. Free online tools by Personal Capital can help you analyze the funds in your account in comparison to outside accounts, so it’s easier to make the best decision.
There’s also the fact that not all 401(k) plans are amazing. It’s worth taking a deep dive into your portfolio and the options available to you. Many 401(k)s offer target retirement date funds, which tend to be less expensive. If you’re investing in stocks or the funds available have high expense ratios, you should (again) run the numbers to see if fees are eating into your profits.
Some people dislike that the money is locked up until you’re 59 1/2. If you want to withdraw funds before then, you’ll pay a 10 percent penalty. Not only that, but in many cases your employer will take about 20 percent out to cover federal income taxes (depending on your tax bracket). That means 30 percent of the balance is gone. Ouch!
There are some exceptions to this, but the requirements can be difficult to meet. You’re better off viewing the money in your 401(k) as money you can’t touch until retirement.
KNOW HOW TO TAKE ADVANTAGE OF YOUR 401(K)
Now that you know the common benefits of your 401(k), you can make an informed decision as to whether or not to contribute, and how much to contribute.
Note that you can also open a Roth IRA if you’d like to diversify your accounts (that’s another retirement account).
For example, if you find that the investment choices in your 401(k) are lacking, but have an employer match, you can contribute up to the match and then focus on maxing out your Roth IRA. If you’ve still got money to spare, you can go back to your 401(k) or open a brokerage account.
If you change jobs, it’s very important that you don’t forget about your 401(k) with your old employer. Absentmindedly leaving it behind, unattended can cause your contributions to become unbalanced. It’s better to keep an active eye on that, even when that means rolling it over to your new employer’s plan or another option.
There are so many options to choose from as far as saving for retirement goes, but your 401(k) is going to be one of your biggest assets, especially when you’re younger. Take advantage of the power of compound interest, automatic contributions and tax-deferred savings and maximize your 401(k) as best you can.
Do you contribute to your 401(k)? Have you always, or did you increase contributions later on? What are some other advantages and disadvantages of 401(k)s you’ve heard others address?
Latest posts by Erin M (see all)
- A Budget Template for New Grads: 10 Steps to Master Your Money - May 21, 2018
- 8 Questions to Ask Before Paying Off Debt - July 17, 2017
- Why You Shouldn’t Let Debt Hold You Back - March 31, 2016